HONG
KONG — Investment banks bringing companies to list on China’s new board for
technology startups are facing an unusual requirement: they will have to keep
some of the shares for themselves.

The
Shanghai Science and Technology Innovation Board marks a major experiment in
the reform of China’s capital markets.

Chinese
President Xi Jinping announced plans in November for a Nasdaq-style board for
young tech startups, and it is expected to be operational later this
year. It aims to attract young companies with fewer regulations and
reporting requirements and, unlike China’s main markets, there are to be no
limits on pricing and first-day trading movements.

Also
unlike the country’s existing boards in Shanghai and Shenzhen, companies that
list do not have to be profitable. In some cases, the tech board will not even
require companies to have generated revenue.

The
board signifies the realization of long-discussed plans to move from a system
where Chinese regulators carefully review every applicant and maintain tight
control over the flow of listings — leading to a backlog of hundreds of
companies waiting years for an official nod — to a more market-driven system
like that of major foreign exchanges.

The
requirement that underwriters take a stake in initial public offerings, first
flagged by officials last month, is an indicator of the authorities’ caution;
members of the Chinese financial community say the stakeholding requirement is
intended to insure underwriters bring only the companies in which they have
confidence to market.

“Having
lowered profitability requirements, it further makes sense to have sponsors
with skin in the game,” said Brock Silvers, managing director of
investment company Kaiyuan Capital in Shanghai.

Executives
with two Chinese financial companies said the minimum stake will be “a low
single-digit” percentage of the IPO. A lock up rule will block the
underwriters from selling their shares within two years of the IPO. The rules
have yet to be formally issued.

Victor
Wang, executive director of financial sector research at China International
Capital Corp., the country’s largest investment bank, said it is still unclear
how the stakeholding requirement will be shared among different investment
banks involved in an IPO. But the logic is, “if you don’t focus on quality
and recommend some low-quality companies, you own money will be lost,” he
said.

China
Merchants Securities, which is sponsoring two companies preparing to list on
the new board, declined to comment about the new rule. However, a local broker,
who had not heard of it before, said he was not surprised at the requirement.

“China’s
financial legal framework is not flawless and officials at the China Securities
Regulatory Commission cannot completely trust sponsors’ due diligence
work,” he said. “After all, there have been IPO frauds before. It is
no surprise if regulators want some level of assurance by having brokers to
share risks.”

Some
market observers are wary of the consequences, however.

“The
intention is a good one but once again investors are not being forced to make
their own decisions and analysis,” said Fraser Howie, a veteran broker and
co-author of three books on Chinese financial markets. “By forcing the
(investment bank) to come in on every deal, it effectively tells investors,
‘Don’t worry. You don’t need to think for yourselves’.”

Howie
also sees the rule as problematic for the banks. “The investment bank’s
job is to bring a company fairly to market,” he said. “I think this
(rule) conflicts with this. To me, they are creating a needless conflict of
interest and additional risk for the bank.”

The
burden of the requirement will favor larger investment banks, in the view of
Yang Yingfei, a partner handling IPOs at Baker McKenzie FenXun Joint Operation
Office in Beijing.

“Sponsors
that are relatively stronger overall will become more competitive, whereas
small and medium-sized securities firms may gradually lose the ability to
sponsor tech board enterprises,” she said. “The effect of
concentration in the sector will become conspicuous.”

Though
the Innovation Board’s approach is unusual, other market regulators have also
been wrestling with the question of how to ensure that underwriters take
responsibility for companies they bring to market.

Last
month, the Securities and Futures Commission of Hong Kong reprimanded and fined
UBS, Merrill Lynch, Morgan Stanley and the securities arm of Standard Chartered
Bank over their handling of IPOs.

UBS
received the heaviest penalty, a fine of 375 million Hong Kong dollars ($47.78
million) and a one-year suspension from sponsoring listings on the Hong Kong
market. The SFC said the bank had failed to confirm the existence of key
claimed assets and customers of China Forestry Holdings before bringing it to
market in 2009 and found problems with its work on two other IPOs.

China
Forestry raised $216 million in its IPO but its shares stopped trading in 2011
after its auditor reported the discovery of accounting irregularities.

Preparations
for the Shanghai Innovation Board have moved unusually quickly since it was
first mooted in November. The authorities are keen to have “unicorns”
— unlisted startups valued at $1 billion or more — list on domestic markets
rather than offshore. After several abortive efforts, they are hoping they have
created an attractive alternative at last.

“There
are certainly signals that the tech board’s IPO procedures will be more
market-driven, with a less onerous process of CSRC approval and
monitoring,” said Peter Fuhrman, chairman of investment bank China First
Capital in Shenzhen. “That should be a positive development.”

Nine
companies are set to launch on the new board as soon as June, but none are
unicorns; combined, they are expected to raise only about $1.6 billion.
Financiers say bigger startups are waiting for the board to work through its
initial launch pains before moving forward themselves.

One
Hong Kong-based banker who works with mainland Chinese companies said “a
lot” of his clients were waiting in the wings.

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